Spain has been under intense market scrutiny since Ireland was forced to accept a bailout at the end of last year, but spending cuts and reforms of the labour, pension and banking sector have kept the wolves from the door.

The premium investors demand to hold Spanish over German debt rose to euro-lifetime highs of over 300 basis points at the end of 2010, but has since stabilised at around 200 bps, still a long way from pre-euro crisis levels of under 60 bps.

Portugal's spread, in contrast, has shot out to over 450.

"What they have done recently in Spain puts them in a better position than Portugal, but the shock waves coming out of Portugal will cause extra pain for Spain," economist at Citi Juergen Michels said. Spain is considered the next weakest link in the euro zone and, with an economy more than twice the size of euro zone peripheral economies Greece, Ireland and Portugal combined, a bailout may stretch the EU/IMF rescue package to the limit.

Analysts have put the possible size of a bailout for Spain at above 300 billion euros compared to estimates of 60-80 billion euros for Portugal and the 85 billion euros granted to Ireland.

Madrid has found no problems finding buyers for its debt so far, although the euro zone debt crisis has shown how quickly markets can turn.

"Spain is being well-funded by investors and is managing its economy and communications with the market much better," said Gary Jenkins, head of fixed income at Evolution Securities. "It's in good shape but I would have said exactly the same things about Ireland 12 months ago." Spain's banks had total exposure of $108.6 billion (94.9 billion pounds) to Portugal at the end of the third quarter of 2010 according to the Bank of International Settlement. Even if a chunk of that went sour, it would not be an insurmountable blow.

FORCED REFORMS

Spain's economy has been stagnant since emerging from 18 months in recession at the start of 2010, has an unemployment rate of more than double the euro zone average at 20.3 percent and has one of the highest public deficits in the euro zone.

In response to the crisis, the Socialist government has passed labour market reforms, prompting a general strike, raised the retirement age to 67 from 65 and overhauled the banking sector.

It also slashed spending, including across-the-board public servant wage cuts and frozen welfare payments from pensions to child support, in an effort to cut the deficit from 11.1 percent of gross domestic product in 2009 to 6 percent of GDP this year.

But critics say that despite an apparently impressive array of actions, the government has done the minimum in response to market pressure and are in denial over the need for real change.

"The reforms are light, and the government is not acting like there's a sword hanging over its head," the president of pro-business think tank Circulo de Empresarios Claudio Boada told reporters recently.

On Wednesday, the government extended the deadline to for unions and business leaders to come up with a deal on reforming collective wage bargaining, sparking criticism the Socialists have relaxed on reforms after a recent easing of market pressure.

But a government official said Spain was bracing for new sell-offs of its sovereign bonds and Prime Minister Jose Luis Rodriguez Zapatero would propose various measures to increase Spain's economic competitiveness at this week's European Union summit.

"He's taking a series of measures, some of them are still possibilities. For example he'll tell the other leaders that labour unions have indicated that by the end of April they could have an agreement on reforms to collective bargaining," the official said.

According to press reports, the government is mulling different options to boost social security and income tax revenue, possibly by offering an amnesty to companies and workers who have unreported wages if they begin paying taxes.

DYNAMIC ECONOMY

Some economists say Zapatero's reactive approach is missing an opportunity to overhaul an otherwise dynamic economy which has produced the euro zone's largest bank Santander, the world's largest clothing retailer Inditex and world's largest wind power generator Iberdrola.

"Spain's economy will suffer if it doesn't make real reforms substantial enough to correct the problems we have," said Alfredo Pastor, economics professor at Madrid-based business school IESE.

"Spain's industry is very dynamic and we have some of the best companies on the world, but they often thrive when they are in an international context and not so much at home. This is because our laws are too rigid and don't allow for that dynamism to thrive as we know it can."

Others argue the cornerstones are in place for longer-term improvements.

"More needs to be done, yes, but it's a really good start and the only way to assess the effect of these reforms is over a longer time frame. It seems to me the initial and tentative results are quite encouraging," Morgan Stanley economist Daniele Antonucci said.

With investors pricing in an imminent bailout for Portugal, the European Central Bank expected to raise interest rates in April, and rising commodity prices over the war in Libya, time may not be a luxury Zapatero can afford.